Buried within Phillips Edison & Company's (PECO) otherwise stellar first quarter earnings call transcript lies a detail that might raise eyebrows at first glance: a potential spike in bad debt. While many analysts might interpret this as a potential red flag, a deeper dive into the company's strategy reveals a potentially bullish interpretation. PECO's aggressive approach to reclaiming spaces from delinquent tenants, driven by sky-high leasing spreads, might actually be a strategic maneuver to unlock substantial value and accelerate its growth trajectory.

PECO operates in a market characterized by unprecedented demand for grocery-anchored neighborhood shopping centers. Fueled by a resilient consumer, favorable demographic trends, and a dearth of new supply, the company enjoys remarkable pricing power, as evidenced by its record-breaking new rent spreads exceeding 37%. This dynamic presents PECO with a unique opportunity: by strategically reclaiming spaces from underperforming tenants, they can swiftly re-lease those spaces at significantly higher rents, potentially driving a surge in NOI.

While the company acknowledges a potential rise in bad debt for 2024, likely landing at the high end of its projected 60-80 basis points range, their bullish outlook on same-center NOI growth remains unchanged. This seeming contradiction hints at a calculated strategy: PECO is willing to absorb a short-term bump in bad debt to unlock a much larger long-term gain through aggressive repositioning and rent increases.

This aggressive approach is not born of desperation. PECO boasts a fortress balance sheet with a low net debt to adjusted EBITDA ratio of 5.1 times and ample liquidity exceeding $570 million. This financial strength allows them to weather temporary fluctuations in bad debt while confidently pursuing a strategy that prioritizes long-term value creation.

Moreover, PECO's confidence is further bolstered by the nature of its tenant base. With 70% of its rents derived from necessity-based goods and services, and a well-diversified mix of national, regional, and local tenants, the company is insulated from major disruptions often associated with large-scale retail bankruptcies.

Consider this: PECO is reclaiming inline spaces and seeing a staggering 40% increase in rents on those spaces. Even if a tenant falls behind on payments, the potential upside from re-leasing at such a dramatically higher rate significantly outweighs the short-term loss. This approach might even be a deliberate decision to hasten tenant turnover and accelerate the company's already impressive growth.

PECO's Inline Leasing Spreads

Here's where the numbers come into play. Imagine a hypothetical scenario where PECO reclaims 1% of its total leasable area, currently experiencing a vacancy rate of less than 3%. If those reclaimed spaces are re-leased at a 40% premium, the company could see a same-center NOI boost of approximately 1.2%. This potential gain far exceeds the potential drag from even the high end of PECO's bad debt projection.

Potential Impact of Reclaiming Leasable Space

The following chart illustrates the potential positive impact on same-center NOI if PECO reclaims and re-leases 1% of its leasable space at a 40% premium. This is compared to the potential negative impact from the high end of their bad debt projection.

It's important to note that this is not a reckless gamble on PECO's part. Their conservative financial management and disciplined approach to acquisitions, consistently targeting unlevered IRRs of 9% or greater, demonstrate a commitment to prudent growth.

This calculated risk on bad debt highlights a key insight: the traditional interpretation of financial metrics might not always hold true in a rapidly evolving market. PECO's willingness to embrace a short-term "negative" to unlock substantial long-term value could be a masterstroke in capitalizing on the exceptional demand for its highly sought-after properties.

In conclusion, while a potential rise in bad debt might seem concerning at first, the context surrounding PECO's strategic approach suggests a more nuanced interpretation. This "red flag" might actually be a bullish signal, indicating a company confidently maneuvering to maximize its growth potential in a uniquely favorable market. PECO's bold move could very well turn out to be a hidden goldmine for investors seeking steady, long-term growth in the resilient grocery-anchored retail sector.

"Fun Fact: The average American household spends about 6% of its annual income on groceries. This highlights the essential nature of grocery-anchored shopping centers and their resilience in various economic conditions."